Private Equity in 401(k)s - What This Could Mean for You

In this episode of Friends Talk Financial Planning, Bridget Sullivan Mermel and Luke Van de Loo about a change that could be happening for America’s retirement system. If private equity starts to make up portions of 401(k) plans, here's what you should know.

Resources:

- Alliance of Comprehensive Planners: https://www.acplanners.org

- John's firm website: https://www.trinfin.com

- Find us on Facebook: https://www.facebook.com/friendstalkfinancialplanning

TRANSCRIPT:

Bridget: Today we're going to unpack private equity in 401(k)s. It sounds like this is going to happen. So, Luke, why don't you just start describing what private equity is and what it's doing now.

Luke: Sure. So private equity is just companies that aren't listed on the stock market in its most pure form. Technically speaking, the dry cleaner down the street is private equity. Over the past 20 or 25 years, the private equity industry has started bundling together a whole bunch of these private companies. There's been tons of money flowing into the space and that has sort of led to a lot of consolidation and a lot of really big private companies.

Bridget: So I think the dry cleaner example is awesome. What happens is private equity might buy up all the corner dry cleaners, and then the owner of the dry cleaner works for the private equity company. And then they bundle all these dry cleaners together, so they think that there's going to be economies of scale. So that means that it's cheaper for all these dry cleaners to be working together rather than trying to do all the dry cleaning on their own and all their systems on their own, like taking people’s clothes in, etc. Talk about what happens to the profits.

Luke: Well, a lot of the profits go to the fund managers. Many of the profits ultimately are used to buy new companies as well, so basically to add to the portfolio. And so, there are many benefits, really, to the private equity industry. It provides some liquidity for business owners and creates these markets where their businesses can be valuable in a way that they weren’t 25 or 30 years ago.

Bridget: Right. So the dry cleaner can then sell their business a lot easier than it used to be able to sell their business.

Luke: Right.

Bridget: And there probably are economies of scale. I've also heard about the usual arrangement. Once it's sold, the people that are working at the private equity firm get 20% plus 2% of something or other. So they're getting a whole bunch of money, and then they get a 2% off the top, and then 20% of the profits, and then the other 80% go to the other investors, the people that have invested in private equity. I don't know if that's accurate.

That's just something that I read. But the point of that is the private equity firm is making money before the investors are making money. So we have to have the dry cleaner make money, then company that owns the dry cleaner makes money, and then the investors make the money. And that I think is especially important when we're talking about 401(k)s. All right, so keep going.

Luke: Sure. So now there's been a shift in the regulatory landscape and there's talk of private equity becoming available or more available in 401(k)s. And specifically, potentially a small percentage of target date retirement funds, which are usually the default 401(k) investment for most 401(k) plans, having a small percentage allocated to private equity automatically. So, for example, if you have the Vanguard Retirement 2040 target, you might end up with a 3% allocation to private equity without even knowing it. Now tell us, Bridget, a little bit about your thoughts about some of the pros and cons of that.

Bridget: Well, there’re some things that I worry about with private equity. Right now, private equity is only available to big institutional investors like pension funds. I'm sure there're some that are accredited investors. And to be an accredited investor, you need to have like a million bucks or make $200,000 a year, something like that. That's the last time I checked the rules. So that means that you have to have some level of sophistication before you can even buy into this.

It also implies that you have some other resources that you're not just depending on this private equity investment, that you've got some other resources going on. When we're talking about 401(k)s, the general person in a 401(k) is not that. That's not what 401(k)s are for. Sure, they accommodate people who are making more and have more. But the person who really is planned for 401(k) is the person that is just starting out with investing, gets it through the work, and leaves it.

It’s set and forget it. It's not, let me be conscious of this. 3% in a target date fund might actually help diversification. But I think that's kind of the little foot in the door and that it would open up more and that pretty soon the appeal to private equity, which is make more money, would be appealing to unsophisticated investors, and they'd lose all their 401(k) money. That's what I'm worried about. So there's a few steps before, the fear becomes realized.

Luke: Right. Well, I think that there is a significant argument to be made that it is reasonable to have exposure to private equity for the average person. So in 2010 the entire private equity market was $1.5 trillion. Fifteen years later, now in 2025, it's $10 trillion.

Bridget: Yeah. Right.

Luke: To give you a comparison, the whole US public stock market is just under 70 trillion. So 10 trillion to around 70 trillion, that's a lot when you compare it to the whole US stock market. And so there could be great returns to be had there, diversification benefits to be had there.

And if it's a very small percentage of a target date fund, it's hard to worry too hard about that. It's unlikely to drive your performance and all these things. So it is not unreasonable from that perspective. There are, I think though, a couple of philosophical worries about this. Who's driving private equity to 401(k)s?

Bridget: Motivation.

Luke: Well, it's the private equity companies. There's talk going around that the liquidity in the space, meaning the money pouring into the private equity industry, is starting to dry up. And what happens when the money dries up? Well, they can't buy any new firms. They might not be able to service debt. So they might have to start defaulting on loans. That could create sort of a storm in the private equity space unless they get a bunch of new money.

And if they access just a few percent of everyone's 401(k), that's going to be way more than enough money flowing into the space to grease the proverbial wheels. So there are significant motivations from the industry that may not have the investors’ best interest in mind per se when they're thinking about this. It may be more of a, “Oh, if we don't get more funds from somewhere, we're going to be in some trouble here.”

Bridget: Yeah. And there’s another metaphor I've heard used with private equity, because a lot of times they don't really want to run these businesses, they want to make them more efficient, which might mean just cutting the staff, getting it to bare bones, working everybody as hard as they can and then selling it. They don't really want to run it. The metaphor I would use is like flipping houses. You buy a house, you fix it up, then you sell it. That's the idea.

Luke: Right.

Bridget: And that's kind of a lot of private equity’s idea. But then if you have fixed up the house, and you can't get the money you want for it, and it's sitting on the market, you don't have any money to buy your next company. And I think that's a situation that again, the rumors say the private equity industry overall finds itself. They have a lot of companies they want to sell that they've fixed up, but nobody wants to buy them. So again, that's rumors, but it rings true. So they're looking for more buyers.

So that's where the 401(k) comes in. Again, I think 401(k) is for the least sophisticated investor. And if people want to get into private equity, there’re ways to do it in your taxable account. And then if the whole thing goes belly up, you can deduct the losses. If you put money into your 401(k) and it goes to zero, you can't deduct the losses on that. You don't get anything. It's just done. So that's my two cents on that.

Luke: The cynical part of me thinks that this may be basically a strategy to unload, like you said, companies that, either aren't worth what the private equity firms are currently valuing them at or want them to be worth. They can just sort of unload those on the public. And if it's only a few percent in a target date fund, all that performance is just going to get looped in with your target date fund and you might not even notice.

And so, the cynical part of me is like, wow, at least the stages set for something that could be sort of nefarious to happen, and almost sort of pulling the wool over people’s eyes at a grand scale. Will that happen? Is that happening? I don't know. It's impossible to know, but the dominoes are sort of there that could allow it to. And as a fiduciary, that's pretty concerning.

Bridget: Absolutely, I agree. Well, it seems like a great time to wrap it up. I'm Bridget Sullivan Mermel. I've got a fee-only financial planning practice in Chicago, Illinois, and Luke is also part of that practice. Luke, why don't you introduce yourself?

Luke: Yeah, I'm Luke, and I'm also at Bridget's firm. If you want, you can check us out below in the description. And we're also part of a larger group of like-minded, tax-focused fiduciaries, and that's called the Alliance of Comprehensive Planners. Link in the description if you want to check out a planner near you. Signing off for today. Don't forget to like and subscribe. See you in the next video.

At Sullivan Mermel, Inc., we are fee-only financial planners located in Chicago, Illinois serving clients in Chicago and throughout the nation.  We meet both in-person in our Chicago office and virtually through video conferencing and secure file transfer.